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Distillate Reveals the True State of the Oil Complex

Author: Brynne Kelly 10/17/2022


The lack of refining capacity growth in key demand centers for diesel means that the outlook remains very uncertain for the remainder of Q4 and likely to be increasingly weather-driven as winter-demand fundamentals kick in.

The world’s diesel markets are flashing warning signs of potential chaos if a demand spike hits this winter. In addition to heating needs, its heavy use in powering trucks, trains and ships are necessary for industry. The fuel is commanding huge buy-it-now premiums in Europe and other Western countries.

Background: The State of Affairs

Going into this season's demand shift there are a few operational loose ends and some concerning low supply data on distillates.

Operationally: Worker strikes for pay increases at French oil refineries have lasted over three weeks and the Continent is now struggling to be ready for implementation of a ban on imports Russia only 3 1/2 months away.

There were, however, signs of relief last Friday as part of the strike action abated. Workers at Exxon Mobil Corp.’s French plants halted their action, although TotalEnergies SE’s refinery in Normandy was still blocked.

Overall painful but known issues. Note however, Europe's problems are US problems when it comes to diesel more this year.

On the inventory side we are headed into winter with some low starting points

  • U.S. inventories of distillate fuel oil depleted to 106 million barrels on Oct. 7, the lowest seasonal level since 1982 when the government began collecting data

  • EU distillate inventories were just 360 million barrels at the end of September, the lowest seasonal level since 2004.

  • Singapore mid-distillate inventories have fallen to just 8 million barrels, the lowest seasonal level since 2007.

Situational Drivers

For those of us that follow oil markets daily, it may sound repetitive but the following cannot be overstated: the lack of refining capacity in key demand centers is leading to worrisome inventory levels and high distillate prices. The reason it will remain the problem is because nothing is materially being done about it yet.

The drivers that have put us in and continue to heavily influence price are refinery closures, supply chain logistic issues, and government policy designed to lessen the use of carbon based fuels at a time when we (or Europe) are boycotting or sanctioning much of the globe's supply sources.

Specifically- U.S. refinery closures brought on by the pandemic, equipment failures and the planned shift to electric vehicles have left insufficient capacity to meet both domestic and rising export demand. One manifestation of this is in the global demand for diesel increasing, while regional refining supply is decreasing

Operable Refining Capacity in the US has been on a steady decline since 2020...

While demand grows globally for diesel in emerging markets like India and China, production remains very regional in the US. This limits what can be used domestically due to the factors mentioned above: reduced capacity, logistics issues, and Net-Zero policy.

Therefore it's important to look closer at regional refining capacity and logistics.

The movement of refined products within US borders is limited by pipeline and rail capacity due to the Jones Act (a 1920 law that requires any cargo shipped between U.S. ports to be carried by U.S. ships, U.S.-built, U.S.-owned, U.S.-flagged, and U.S.-staffed).

Roughly 54% of refining capacity in the US is located along the US Gulf coast. Meanwhile the most significant decline in US refining capacity noted above has been along the US East Coast, where a large amount of demand still resides.

PADD 1 Refining Capacity has seen the most significant declines...

US diesel enjoys significant overseas pull for refined products from PADD 3 now. There is also a lack of ease in pushing that same PADD 3 capacity domestically to PADD 1, where it is most likely to be needed this winter

EIA map of the Petroleum Administration for Defense Districts (PADDs)...

PADD 3 exports to Europe. PADD 1 keeps most of its own remaining refining capacity but must import from Europe to cover shortfalls.

Refining closures in PADD 1 coupled with the Jones Act have forced the US East coast to be reliant on foreign imports to meet peak demand. This year, distillate supplies have been struggling to keep pace with demand over the summer. This is due, in large part to the war in Ukraine. Inventories are therefore low and domestic prices continue to rise in order to attract imports to the East coast region.

Conversely, U.S exports of distillate fuel out of PADD 3 reached a record 1.76 million barrels in September, with more than 633,000 barrels of diesel sent to Northwestern Europe, according to Refinitiv data. We export our refined product from the US Gulf Coast and import refined product into the US East Coast from foreign countries (a function of the Jones Act).

This is having an impact on US East Coast distillate inventory levels.....

Refining capacity will be going up, but not fast enough for this winter, and not locally. In the International Energy Agency’s (IEA) June 2022 Oil Market Report, the IEA expects net global refining capacity to expand by 1.0 million b/d in 2022 and by an additional 1.6 million b/d in 2023. Net capacity additions reflect total new capacity minus capacity that has closed.

New Refining is Coming, Just Not Here

The most global refining capacity under development is in China. Chinese capacity is scheduled to increase significantly this year because of the start of at least two new refinery projects and a major refinery expansion. In fact, the country is expected to continue increasing its refining and petrochemical processing capacity through a number of additional projects expected to come online by 2030. Most noteworthy among these additional expansions are the 300,000 b/d Huajin and the 400,000 b/d Yulong refinery projects, which both have target start dates in 2024.

Although no projects to build new refineries in the United States are currently planned, major refinery expansions are underway at a handful of Gulf Coast refineries, most notably ExxonMobil’s Beaumont, Texas refinery, which plans to increase its capacity by 250,000 b/d by 2023.

No new Refining Capacity on the Horizon for the US...

In the United States, political pressure is mounting for refiners to increase domestic INVENTORIES. Note the important distinction: political policy is not pushing to increase domestic refining capacity, rather it is focused on increasing inventory ahead of the winter season.

Additionally, it has even been suggested that one way to accomplish this would be to waive the Jones Act to allow US Gulf Coast refined products to be transported to the East and West coasts via ship. This may sound good on paper, but it takes more than pushing political paper to accomplish this.

Currently, the fleet of U.S. vessels that comply with the Jones Act restrictions has dwindled from 2,300 in 1946 to less than 100 today, and many of those ships are old and among the most expensive in the world to maintain. We just do not have the shipping infrastructure to accomplish this even with a waiver right now, at least for the immediate future

Market Impact

Energy is a flow trade not a stock trade. Once produced it is consumed. The lack of immediate supply at reasonable prices is currently being partially mitigated by government subsidies and other stimulus-like responses. But that does not solve the ongoing supply problem.

What's more; lower Oil prices have a diminished effect on the price of distillates in the short term due to demand inelasticity. Lower oil prices actually cause an increase in distillate prices in the long term due to reduced CAPEX in production, as we are now experiencing first hand.

Getting the price of oil lower while subsidizing diesel demand ( like in Europe) only creates bigger refining margins. And once that capacity is maxed out, there is only upside risk and prayers for warm weather.

Distillate Untethered

The above is evidenced by price action where Oil is not leading markets higher, rather it is lagging when it comes to dictating energy complex price. There are also no immediate economic fixes that solve the long term supply imbalance we have now. And building a refinery (a long term solution) will not solve this winter's issues. Supply is therefore also inelastic!

The most recent short-term solution by the US to the oil price problem has been to release barrels from the SPR. While this has kept pressure on oil prices, low distillate inventories and limited refining capacity have untethered distillate futures from their once correlated relationship to both oil and gasoline.

Traders tend to validate flat price levels via spread relationships, so next we will take a look at some key calendar, crack and inter-product spreads to see if we uncover anything.

Calendar Spreads

Traders are now focused on winter. Toward that end, we take a look at a key distillate 'winter' versus 'summer' spread (January vs April) past, present and future.

Here we begin to see the winter issue. We are well above historical highs in the upcoming 2023 seasonal spread. With all that has been thrown at oil markets to try to contain prices, the problem is magnified here in distillate spreads. This spread is now behaving more like a flat price trade than a spread trade. Don't be surprised if they start raising margin requirements on spreads as a result. We are not predicting this, but note that when commodity spread correlations get outside normal risk volatility levels ( like CME Span margins), they can raise margins on spreads.

Crack Spreads: The Problem Visualized

As global demand for petroleum products returned closer to pre-pandemic levels through 2021 and early 2022, the loss of refinery capacity contributed to higher crack spreads

Interestingly Diesel and Jet Fuel crack spreads are exploding higher (wholesale gasoline not so much) as refinery supplies struggle to refill inventories.

Refining crack between NYH distillate and Brent futures....

Capacity limitations are the reason we are here. High prices are not unearthing new supply as they have in the past because the 'supply' needed in the short-term is refining capacity.

Currently we don't see much evidence that there is a plan in place to arrest this problem. High prices are not stimulating normal commercial responses that would lead to long-term resolution due to an uncertain regulatory future. Companies are more likely to give one time dividends or buy back shares than increase CAPEX in a business restricted from growing The only things on the horizon are subsidies and perhaps another round of stimulus checks ( Gas cards?) to keep the public at bay. This based on past behaviors here and current plans in the EU.

Inter-Product Spreads

As the holiday season approaches, trucking and industry comes in to focus. Trucks use diesel, not reformulated gasoline. As a result, these two asset classes have nothing to do with one another right now.

First Quarter Gasoline trades at more than a $40/bbl discount to Distillate

The distillate problem is acute. And when people are in crisis, they lose perspective and only care about the thing that is right in front of them - which for now is the distillate shortage. Tankers are being rerouted, to that effect as problems need to be solved.

Spot Gasoline vs Distillate spread is volatile as Gasoline nears a $60/bbl discount to Distillate...

Creative Solutions During Crisis

Traders are diverting Europe-bound tankers carrying diesel to the U.S. East Coast as the two regions battle for supplies amid an acute shortage and soaring prices.

At least two tankers carrying 90,000 tonnes of diesel and jet fuel are heading from Europe to the U.S. East Coast, according to traders and Refinitiv ship tracking data.

The Thundercat, carrying a cargo of diesel from the United Arab Emirates, on Thursday changed its destination from the Dutch port of Rotterdam to the New York Harbor, according to shipping data. It is currently in the Mediterranean.

Such diversions are rare as Europe, where refineries do not produce enough diesel to meet domestic demand, typically imports diesel from the United States as well as Asia and the Middle East.

Bottom Line

Oil prices are lower and less frothy, but the problems we had in the summer are the same ones we have now, lack of refined product supply. This time it is Diesel. Not only is it key for heating demands at the domestic level, it is key for supply chain logistics like trucking and bigger economy stuff.

The fixes are financial and will be subsidies, price caps, and other short term mitigators. There seem to be almost no moves to lessen the longer term supply situation by Net-Zero design. If push came to shove, we cannot even easily move PADD 3 supply to PADD 1 demand and must compete with Europe for winter distillates.

The lack of refining capacity growth in key demand centers means that the outlook remains very uncertain for the remainder of Q4 and likely to be increasingly weather-driven as winter-demand fundamentals kick in.


EIA Inventory Recap - Week Ending 10/09/2022

Weekly Changes

The EIA reported a total petroleum inventory DRAW of 0.60 for the week ending October 9, 2022. Commercial inventories however, posted a large weekly BUILD of 9.90 while SPR inventories DREW by (7.70).

YTD Changes

YTD total petroleum EIA inventory changes show a DRAW of (207.70) through the week ending October 9, 2022. The bulk of this is due to drawdowns in SPR inventories.

Inventory Levels

Gasoline and Distillate inventory levels are now both decidedly below their 5-year average for this time of year.


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1 Comment

Chris Kanaan
Jan 02, 2023

Great article. Exceptional. Thanks for that one as always.

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